After falling 15 votes shy of the 60 needed to close debate and move forward on the “extender plus” package, Finance Chairman Max Baucus offered up a second substitute last evening and Senator Reid immediately filed a cloture motion to end debate. That motion requires 60 votes and the vote would take place on Friday.

The new Baucus substitute is “slimmer” than the previous effort and apparently was designed to mirror the deficit impact of the House-passed bill. As such, its goal is not only to attract 60 votes in the Senate, but also to pass the House as well. As CongressDaily noted:

The effort appears calculated to not only get 60 Senate votes — and at least one wavering Democrat, Sen. Evan Bayh of Indiana, signaled he plans to support the bill — but get though the House. The new version would add roughly the same amount to the deficit as the “extender” bill that passed the House on a 215-204 vote before Memorial Day.

On the payroll tax issue, the substitute makes significant changes that narrow the scope of the test while apparently expanding the base of S corporations that would be affected. The Committee summary reads like this: 

A provision passed by the House and included in the original Baucus substitute would address this abuse in situations where (1) an S corporation is a partner in a professional service business or (2) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals. This provision does not change the ability of S corporations to use some income to make business investments or deduct those small business investments. To make the second alternative more administrable and more targeted, this amendment changes the language so that the policy applies only if 80 percent or more of the professional service income of the corporation is attributable to the services of 3 or fewer owners of the corporation. This proposal, as amended, is estimated to raise $9.15 billion over 10 years.

As the summary indicates, “Baucus II” would replace the flawed “principal asset test” with what might be described as a “principal rainmaker” test — if three or fewer shareholders bring in 80 percent or more of the firm’s gross income, then additional payroll taxes would apply. Here’s the section:

(ii) any other S corporation which is engaged in a professional service business if 80 percent or more of the gross income of such business is attributable to service of 3 or fewer shareholders of such corporation.

On the surface, that’s a big improvement over the “principal asset” test. Our advisors believe it would be easier to administer and less subject to litigation than the earlier version. That said, the key question for policymakers is not whether Baucus II is better than the untested House-passed version, but whether it’s an improvement over current law.

We convened our advisors last evening and their opinion was that it’s not an improvement over current law, especially for firms that don’t already track hours and directly attribute revenues to certain shareholders. Law firms and CPAs usually are set up that way; engineering consultants and architects often are not.

Keep in mind, the IRS can and does go after tax avoiders (its tax avoidance it’s illegal; it’s not “fraud” or “abuse” or a “loophole”) using the reasonable compensation test. They just won a big case out in Iowa using that standard. So how is having the IRS enforce a “principal rainmaker” test any easier?

Other changes, or lack of changes, are also troubling. The pool of S corporations affected by this new version appears to have expanded. The House-passed definition of “Professional Services Business” reads like this:

For purposes of this subsection, the term “professional service business” means any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

The new version reads the same, except they took out the words “substantially all of the activities of such a trade or business involve”, which begs the question, exactly how much lobbying or engineering or investment advice do you have to provide before you fall into the “Professional Services” pool?

The flawed “Family Attribution” paragraph remains intact. This provision discriminates against inactive family shareholders and sets the stage for further assaults on family-owned businesses in the future.

Finally, the provision continues to target firms with “3 or fewer” key shareholders. As we’ve noted, 94 percent of all S corporations have “3 or fewer” shareholders, but other than that threshold, we do not understand the significance of “3″. The GAO, TIGTA and others have identified single-shareholder S corporations as the predominant source of this problem.

Sharing our concerns, Senators Snowe and Enzi re-filed their amendment to strike this provision from the new substitute. We are continuing to work with those offices and others to highlight our concerns with this provision and get it struck or significantly amended.

If you are an S corporation and you provide any of the services listed above, now is the time to reach out to your Senators and let them know how this would affect you. The next key vote is scheduled for tomorrow, and the entire package could be finished and sent to the President by the end of next week, so now is the time to act.